8-18-06
Points
Last month we revisited “The Homebuyer’s Vocabulary List” to demystify some of the numerous terms and phrases you will encounter as you pursue your first home purchase. There was one piece of the vocab puzzle that I left off the list because I felt it deserved an entire article of its own. That term is… points! [Note: If you missed either of the “The Homebuyer’s Vocabulary List” articles, you can find them in the archives.]
If you ask your friends and family for advice as you consider your home purchase, one thing they will almost always tell you is, “Make sure you don’t pay any points!” This advice is true most of the time but not always. And what are these “points” anyway?!? Let’s take a look.
What are points?
The official definition is: “One point is equivalent to one percent of the loan amount.” For example, for a $200,000 mortgage, one point would be 1 percent of $200,000, or $2,000. If you pay a point up front, you will receive a lower mortgage rate. (In addition, mortgage points are considered a form of pre-paid interest by the IRS, meaning that mortgage points can be deducted from taxable income).
Seems pretty simple, right? So let’s ask the $2,000 question…
Should you pay points?
So when you pay “points,” you pay interest in a lump sum up front to get a lower rate on your fixed rate mortgage. The more points you pay, the lower your mortgage rate. So, which is the best for you, more points and a lower rate or no points and a higher rate? To decide, you need to consider: 1) whether you can afford to make the up front payment now for points; and, 2) the length of time you expect to have the mortgage. The longer you plan to have your mortgage, the more it makes sense to pay for points now because you’ll have a long time to benefit from the lower rate.
For example, let’s say the standard 30-year fixed mortgage is currently at 6.5 percent. You are securing a $200,000 mortgage for the purchase of your new home. If you pay one point, or $2,000, up front, the mortgage will have a 6.125 percent rate for the life of the loan. Should you pay for that point? Well, unless you have one of those fancy mortgage calculators, you’ll need to have your loan officer crunch a couple of numbers for you before you decide.
Let’s crunch. With a $200,000 mortgage at 6.5 percent, you will have a monthly principal and interest payment of $1,264.14. With a $200,000 mortgage at 6.125 percent, you will have a monthly principal and interest payment of $1,215.22. So that point will save you $48.92 each month. If we divide the cost by the savings, we find that it would take $2,000/$48.96 = 40.88 months for you to start saving money. So if you plan on staying in the property for more than 41 months or around 3.5 years, paying a point might make sense (for the record, over the life of a 30-year loan, the savings by paying that point would be $17,611.20 minus the $2,000 cost for a total savings of $15,611.20).
So why don’t people pay points more often?
While 3 years might seem like an realistic length of time to live in a particular property, there are so many factors which could result in your selling the property or terminating the mortgage that many folks stay away from paying points. You could get a new job and have to move to North Dakota; you could fall in love with a man/woman that lives in North Dakota; or, more realistically, you could refinance. If you are making a down payment of less than 20 percent, there is a pretty good chance you will refinance within the first three years of the mortgage.
Be careful!
In my personal opinion, I think the real reason many people are skeptical about paying points is because home buyers often wind up paying points without knowing it. As a result, “points” have earned a bit of a bad rep.
Let me explain: there are a couple of ways that loan officers can, for lack of a better word, “sneak” points into your closing costs. The terms “loan origination fee,” “loan discount” and “discount points” are all pretty much interchangeable with the common abbreviation “point.” So you look over your closing cost breakdown (also known as the “good faith estimate” or GFE) and there are no points included but there is a $2,000 loan origination fee amid several other closing costs. You probably think nothing of it, since it’s your first time buying a home and you know that there are considerable closing costs up front. However, that $2000 loan origination fee is, in effect, the same as a “point” but may not be getting you a lower mortgage rate and may be an unnecessary closing cost in this case.
Unfortunately, the above scenario happens pretty frequently, so what is most important here is that you ask your loan officer if you are paying any points. Whether the loan officer is your best friend’s uncle or someone you met through a home buying seminar, it doesn’t matter – always ask! Then look over your closing cost breakdown for “loan origination fees” or “loan discounts” and have your real estate attorney do the same at closing.
I really don’t mean to scare you here, but rather to give you the tools you need so you can pursue your first home purchase confidently and intelligently. The bottom line: it’s worth taking the time to see if paying a point makes good financial sense for you. Simply crunch the numbers as we did today, then consider how long you plan to live in the property and you might be able to save a bunch of money in the long term!
As always, feel free to call or e-mail me anytime with any home buying questions you may have. Also, please send me any comments or suggestions about this article and let me know if there are topics you would like to see discussed. Talk to you next month!
Mike McNamara has been an actor in Chicago for the past eight years in theatre, commercials, television and film. Mike is also a Loan Officer with West America Mortgage Company. He can be reached anytime at 773/398-0021 or McNamara310@aol.com. Special thanks to Jim Morley, Assistant Vice President of West America Mortgage Company (and Chicago theatre actor) for contributing to this article. Jim can be reached at 773/594-9777 or at JMorley@wamc.com.